It was the best of times, it was the worst of times

Pension funds in the US have been dealing with a unique set of stressors and opportunities as they work their way out of the financial crisis, but the way in which public and corporate schemes emerge from the gloom will be drastically different. 

While corporate funds dial down risk, public funds appear to be more tactical in their investments, scooping up opportunistic investments in an attempt to build up returns.

Like pension funds all over the world, assets took a beating, liquidity was scarce and investors were paralysed with fear not knowing when the next shoe was going to drop. 

But overlaying the global concerns were issues that were distinctly American – a projected US$9trn federal deficit triggered inflationary fears while accusations of pay-to-play at government pension plans ruled the headlines. 

Meanwhile, as the equity markets rebound, investors are hopeful the recession has come to an end, and are repositioning their portfolios to take advantage of upcoming opportunities. 

“The last 12 months have been two very different years – a horrible year and a good year. Unfortunately, when the horrible comes first, the recovery... would have to be spectacular,” said BNY Mellon Asset Management chief investment strategist Phil Maisano. 

BlackRock head of US institutional group Robert Capaldi said: “The market turmoil caused significant pain for pension funds, both corporate and public... But if you look at major trends, there continues to be a significant divergence between public plans and corporate plans that is accelerating. 

“On the public fund side, because they don’t face the same accounting issues that the corporate plans face, we continue to see a focus in higher return generating assets and increasing their focus to those.”  

Public pension plans have been turning to equities and alternatives to bring in returns. 

Illinois State Board of Investments executive director Bill Atwood said: “On the corporate side, it’s more due to regulatory pressures. We’re about 40% funded. My job is to get an 8.5% rate of return, not preserve capital... We’re willing to take more risk in less efficient markets.”

But for a large public pension fund, taking advantage of niche opportunities won’t be easy. 

“What makes public pension funds unique is that they have a lot of capital. They’re big enough that if they try to take advantage of ‘fill in the blank’ opportunity, they may affect pricing,” said Goldman Sachs chief investment strategies Kurt Winklemann. 

 

Looking at other investment avenues

Other pension fund officials have been turning to the alternatives markets for returns. 

“This market presented a lot of opportunities to position ourselves for longer term returns,” said San Francisco City and County Employees’ Retirement System deputy director for investments David Kushner. “The difficulty is getting past the declines.”

Kushner said he’s been taking advantage of the opportunity created in the secondary private equity and real estate markets as foundations and endowments looked to sell off their holdings. 

“Everybody was pulling in saying, ‘We have to go to cash, sell private equity in secondary, sell our real estate holdings.’ We saw that as an opportunity. We told our general partners we were ready purchasers of secondary positions,” said Kushner.

The extent of the opportunity in the secondary markets, when managers buy and sell pre-existing investor commitments, was exasperated in the US because of the country’s huge foundation and endowment community, industry experts said. 

“We got a lesson on liquidity that was a very difficult one, with the endowments being the ultimate example of this. The endowments felt, ‘We’re here in perpetuity, we don’t need to be liquid and as a consequence of that, we’re going to buy investments that we think have better long-term return characteristics,” said Maisano.

“They underestimated the need for liquidity,” he said, and as a result, became forced sellers of private equity investments. Industry watchers say they expect similar actions in the real estate market, though force-selling there hasn’t come into play yet. 

Consulting firm Mercer has been exploring the secondary market for its clients as well. 

Mercer worldwide partner Robert Burke said a client who invested in private equity for the first time in 2008, has so far built its entire portfolio on the secondary market. “They’ve had more supply to pick from, unexpectedly,” he said. 

The scheme targeted $200m in private equity, and is about two-thirds of the way invested, he said. 

“Diversification in vintage years is an important part for people who are going to enter these asset classes who haven’t been in there.”

The liquidity issue underlay most decisions schemes made last year about investments – whether it was exploring a rebalancing strategy or jumping on new opportunities. 

“The big question was, do you rebalance? Do you raise cash or not? We recommended that clients rebalance. The thought process was that you needed to follow the discipline,” said Burke.

“Most of the public funds find themselves in a very big struggle to find liquidity,” said Winklemann. 

 

Targeting cash

Some investors have been shoring up cash. 

“We’re accumulating cash more frequently than ever and cash used to be a curse word around here,” said Chicago Policeman’s Annuity and Benefit Fund executive director John Gallagher. 

Gallagher said pension staff was “walking on a balance beam” last year trying to ensure it had enough liquidity to make benefit payments, but also to take advantage of some opportunistic investments. 

“I didn’t want our board to freeze in the headlights and miss opportunities in this economic Armageddon,” he said.  

“We made a couple of short-term tactical investments that are paying off well, but nothing I’d want to do long-term. (The trustees) have passed on a couple of things, but to their credit, they took a couple of opportunistic steps, too.”

Illinois State Board’s Atwood said he’s changed the way he looks at risk within the portfolio, and a result of that has been an increased awareness of liquidity issues. 

“We’re cognisant more so than in the past of the necessity of liquidity,” he said. 

“If we decide that we want to lengthen our fixed income duration, do we have sufficient liquidity to lengthen that duration?  If we see evidence of an inflationary environment, we want to make sure we have sufficient liquidity to adjust the portfolio to reflect that,” added Atwood.

 “Conversely, if... we go into a prolonged period of a deflationary cycle, do we have enough liquidity to make those kinds of adjustments?”

The issue of inflation has come to the forefront as investors wonder how the government plans to unwind an expected $9trn in debt. 

“For me, it’s a huge concern... it’s on the front burner,” said Atwood. 

“It’s a giant unease but people don’t know what to do about it. The $9trn deficit is the elephant in the room,” agreed Burke. 

But the federal government has provided some opportunities for investors looking to scoop up assets, though neither were as widely used as anticipated. Last year, the government launched the Term Asset-Backed Securities Loan Facility (TALF) and the Public Private Investment Program (PPIP). 

The TALF programme allows investors to obtain cheap credit from the government and use that to buy securitised consumer loans. The programme was meant to jumpstart the mortgage backed securities market. 

With the PPIP programme, the government hired managers to help sell toxic assets from banks’ balance sheets. 

Despite the hubbub surrounding the programs, institutional investors didn’t take to them as much as some had expected. 

Gallagher said the Chicago Policeman’s board looked at the TALF programme but decided not to invest. “The trustees felt there was still too much risk in the distressed debt sector. We thought it was worthwhile, but the board passed,” he said. 

For PPIP, Gallagher said the scheme already employs three opportunistic fixed income managers, and didn’t need another. 

Atwood said he passed on TALF because “a leveraged loan portfolio is a leveraged loan portfolio,” even if it is backed by the government. 

But the most important impact the two programmes had can’t be measured by the amount of assets invested, but by the psychological impact it made on investors, some industry watchers said. 

“None of these programmes were as heavily used as people thought they would be... but they created a floor in the markets,” said Maisano. 

“In many ways, it was more successful than they thought because it opened up the private markets,” he said. 

 

Pay to play in the spotlight

Another issue that has surfaced in the past year has been a concern over pay-to-play practices among third-party marketers vying for pension fund business. 

In July, Securities and Exchange Commission proposed rules to crack down on pay-to-play practices by preventing managers, marketers and advisers from making political contributions. It would also ban the use of third-party marketers. 

The proposal comes amid an investigation by New York attorney general Andrew Cuomo and the SEC surrounding pay to play practices at the New York State Common Retirement Fund. 

The investigation has led a number of managers and third party marketers to return money to the Fund in order to resolve their roles in the investigation.

But pension funds and other industry experts have been railing against the proposed rules saying the outright ban on third-party marketers will do more harm than good. 

In a comment letter to the SEC in August, Missouri State Employees Retirement System chief investment officer Rick Dahl said: “Prohibiting legitimate placement agents from working with public pension funds is an extreme measure that will have unintended consequences; that is, it will reduce our ability to access some of the best managers throughout the world and ultimately result in lower investment returns for our members.”

Other scheme managers agreed. 

One manager, who requested anonymity, called the plan “absurd” and said it would “kill smaller managers”. 

Chicago Policeman’s Gallagher said: “Like most things, it’s over-reaching. It’s another example of the government over-reaching in response to a disaster.”

Illinois State Board’s Atwood said the state has already banned the use of third-party marketers and that the SEC is in the best position to intervene. 

He said: “Nobody on any side of the table has stepped up to do anything about it. I think the SEC is best equipped to regulate that space.” 

 

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A time of change for corporate pension funds

Corporate pension funds in the US have been moved less by the unprecedented markets in the past year and a half, and more by a convergence of regulatory changes that have brought liabilities to the forefront. 

Funding regulations in the Pension Protection Act (PPA) of 2006 came into effect in 2008 and put the issue of shortfalls in pension schemes on companies’ front burners. Meanwhile, accounting standards requiring valuations on hard-to-value assets went into full force in 2008, making some trustees shy away from alternatives. 

The result has been a large-scale de-risking with billions of assets shifting into fixed income as plan sponsors look to match their assets to their liabilities – a sharp contrast to their public counterparts who have been scooping up opportunistic investments. 

Consulting firm Mercer, for example, conducted 26 fixed income searches worth US$4.7bn in the first half of the year, versus 11 worth $1.1bn the previous year. The consultant said searches were partly driven by the move towards liability driven investing, and partly by investors replacing underperforming fixed income managers. 

 “The regulatory landscape has been the bigger mover for them to change than the economic landscape,” said Watson Wyatt Worldwide central division practice leader Steve Carlson about corporate plans. 

Watson Wyatt’s corporate clients have decreased equity exposure by 5% to 10%. 

 

The road to LDI

The trend towards liability driven investing, the practice of matching your assets to liabilities as a way to lock in a funding status and incubate a company from contribution swings, has picked up steam in the past year. 

But the practice has taken on a new form. Russell calls it liability responsive asset allocation. Mercer calls it dynamic de-risking. 

Underpinning the new incarnation of the strategy is recognition that the assets can’t automatically be shifted into longer-duration products until the plan is fully funded. Instead, risk is slowly removed as funding and the markets improve. 

Russell, director of investment strategy Bob Collie said: “Clients have been setting a particular level of risk, a particular level of equity, today. But at the same time, maintaining a schedule that says, as things improve, we are automatically taking that risk off the table.”  

Northern Trust senior vice president of investment management solutions Steven Miller and chief executive officer Alan Robertson said clients have been requesting asset allocations reviews. 

Miller said: “A lot of clients are saying, ‘Gee, can we go back to 2007 and do liability driven investing?’ The horse has left the barn, and they know that. But now we’re seeing a lot of interest in…if they get to 100%, what can we do asset allocation-wise.”

He said there wasn’t an urgency three to five years ago to take risk off the table mainly because plans were already 100% funded. Also, at that time, a shortfall didn’t have a direct impact on shareholders, said Miller. 

But with new funding requirements in place, already cash-strapped companies find themselves needing to pour even more cash into their pension funds. 

Mercer world wide partner Robert Burke said the “twin” of asset allocation and funding is on the top of investors’ agenda. 

He said: “In the US programme, unless there’s a relief from the PPA soon, you’ve got to get back up to full funding…A lot of cash is coming out of the company to make it up.”

Mercer’s dynamic de-risking strategy, which the consultant is currently promoting in the US, parallels Russell’s in that it establishes pre-agreed watermarks to reach before taking risk off the table. 

Trustees are looking at this option as funding levels continue to get hammered. Data by Milliman showed at the end of August, exactly one year after the largest 100 corporate schemes were fully funded, solvency levels had dropped to 75%. 

 

Alternatives

Separately, the accounting standard FAS 157 affected the way corporate pensions looked at alternative assets. The accounting rule came into effect for companies with fiscal years starting after November 2007. 

FAS 157, issued by the Financial Accounting Standards Board, expanded the definition of fair value and expanded the disclosure requirements for assets valued at fair value. 

“One of the biggest issues on everybody’s mind right now is valuation. These are often hard to value assets,” said Winston & Strawn, attorney, Julie Stapel.  

Julie added: “The Department of Labor in the summer of 2008 indicated that in these types of vehicles (alternative assets), plan fiduciaries might need an independent third-party valuation. This presents a lot of difficulty... Adding a third-party valuation expert is going to add cost.”

Watson Wyatt’s Carlson said: “FAS 157 had impact more so for some of the alternative asset classes because it forces the plan sponsors to have a process that they can talk to their auditors about that independently values the alternative assets. 

“FAS 157 has somewhat limited plan sponsors ability to look at alternative asset classes.”